Four Basic Steps to Gauging a Firm's True Financial Position

Understanding a company is similar to understanding your own personal finances. In fact, if you look at a company's financial statements, you will find that they are similar to our own "personal" financial statements. However, for most of these, there is a different basis for how items are reported. Table 1 provides a simple analogy.

TABLE 1. Financial Statements: Corporate and Personal Similarities

Corporate Statement

Personal Statement

Balance Sheet

Mortgage Application

Cash Flow Statement

Checking Account Statement

Income Statement

Personal Tax Return

Footnotes to Financials

How you explain your finances to an investment advisor or IRS auditor

If you were to analyze your own finances, you typically would start by looking at how much money you have in your checking account and at the transactions posted to your account. This usually represents "the truth" about how you really spent all of your money.

This is very much how analysts look at corporate financial statements—starting with the cash flow statement—to get at "the truth."

This article outlines four basic cash flow analysis steps you can use to better understand a company's financial position.

1: Study the Cash Flow

The process starts with an understanding of the cash flow statement.

Imagine how a bank investigates you when you're applying for a mortgage to buy your first home. The bank wants to know everything about your income tax filings, bank statements, pay stubs, debt payments and credit score before approving you for a loan. They are looking at your "cash flows" to see how you've really managed your personal cash flows or business.

You should begin looking at a company with the same approach, using the cash flow statement to provide you with a greater sense of how the business model really works—where does cash come from (source of cash) and where does it go (use of cash)?

The cash flow statement has three parts, although the components may vary depending on the type of business the company engages in:

Cash flow from operating activities—describes cash coming in and going out from a company's day-to-day business.

Cash flow from investing activities—describes cash coming in and going out from longer-term purchases, asset sales or investment accounts.

Cash flow from financing activities—describes additional sources of cash coming in or going out from interest paid, interest received, loans, bonds sold or stock issued.

Each of the line items in the cash flow statement indicates whether cash was spent or received. For example, if accounts receivable increased by $100,000, this tells you that there was a use of cash, which will be depicted as -$100,000 (the negative sign indicating that product went out the door). An accounts receivable item indicates that a customer was given credit to pay the bill later, even if the sale has already been made. But cash has not been received and, hence, if accounts receivable increases, it means that more bills have not been collected and the cash has been "used."

You might also see cash flow from the issuance of stock of, for example, +$1,000,000, which indicates that stock was issued and was a source of cash (the positive sign showing that cash came into the company).

2: View It as a Time Series

You should view the cash flow statement as a time series in a spreadsheet. A time series looks at the cash flow statement on a yearly and a quarterly basis. Here's what you will be looking for:

Management Actions
Seeing cash flows over time reveals what management is really doing, where the cash is coming from and how management uses the possibly scarce cash resources of a company.

Management Strategy
You should try to mesh management's use of cash flow with management's growth strategy.

Where do you find the company's strategy?

SPECIAL OFFER: Get AAII membership FREE for 30 days!

Get full access to AAII.com, including our market-beating Model Stock Portfolio, currently outperforming the S&P 500 by 4-to-1. Plus 60 stock screens based on the winning strategies of legendary investors like Warren Start your trial now and get immediate access to our market-beating Model Stock Portfolio (beating the S&P 500 4-to-1) plus 60 stock screens based on the strategies of legendary investors like Warren Buffett and Benjamin Graham. PLUS get unbiased investor education with our award-winning AAII Journal, our comprehensive ETF Guide and more – FREE for 30 days

Most of the time you can find this within the company's 10-K report under the following sections: business overview, management strategy and competition, and management discussion and analysis (MD&A). This is important because you need to see whether management is putting its money where its mouth is.

Industry and Economic Trends
These help you understand why the company is implementing its current strategy (or what strategy it should be implementing).

The worst possible scenario is when you see industries consolidate, margins shrink, cash flows from operations decline and a management that is dependent on a high share price and acquisitions to keep growth rates high per expectations and perceptions. Aggressive accounting becomes almost inevitable.

As you look at the time series of cash flows, you start to understand how the business really works, and you might even be able to get a sense of what vulnerabilities the company is susceptible to.

3: Compare to Other Items

The next step is to compare cash flow with other financial statement line items. This separates how the company says it grew and how it actually grew, via the use of the time series of cash flows.

Compare growth rates in cash flow from operations versus growth rates of revenue and net income.
You will sometimes see companies touting growth in revenue and net income, but you might find that cash flow from operations are in decline. Looking at the line items that impact this tells you the truth about how the company is really doing.

Reread recent press releases from the company to gauge the difference between what the company touted and what really is going on.
You may notice that what you saw when you first read about a company's newly released financial statements based on corporate press releases is not what you see after you do the calculations.

Calculate an estimate of free cash flow.
This can be done by taking cash flow from operations and subtracting capital expenditures. This is money the company has after it reinvested into maintaining its business and competitiveness within the industry—essentially what is "free" to invest in "extra" growth potential.

Calculate growth rates of free cash flow over time versus growth rates of revenue and net income.
Free cash flow over time can be volatile for smaller companies given choppy reinvestment amounts, but over time it indicates the long-term cash flow health of the company.

Doing these calculations will compel you to ask questions about the results and encourage you to look deeper into the line-items that made the most impact.

One key caveat: Make sure that you compare growth rates year-over-year to eliminate seasonality. Growth rates are highly volatile within the year and between quarters. Example: Comparing second quarter with first quarter doesn't compute. Compare this year's second quarter with last year's second quarter.

4: The Footnotes

Last but not least, make sure to read the footnotes. Do not read these first because you will not know about the company's business model, usually found in the business overview section of the 10-K report.

Reading the footnotes takes time, but they're the best guide about how the items on the financial statements are being measured and reported. In particular, read the following sections:

Changes in accounting policy,

Revenue recognition,

Debt discussion and any off-balance sheet debt (operating leases and securitization of receivables),

Stock options,

Pension accounting,

Acquisition analysis,

Acquisition/asset impairments or goodwill write-downs, and

Segment reporting.

As a general rule: The longer the discussion of a particular footnote, the more this footnote may become the central issue of your analysis.

The Initial Steps

Cash flow analysis can be a complicated process. However, as an initial four steps, the process outlined here will give you a much better understanding of the true financial position of any company that may be of interest.

Jay Taparia, CFA, is principal, Sanskar Investments, Inc.; director of education, Investment Analysts Society of Chicago; and professor/lecturer at the University of Illinois at Chicago.

This article originally appeared in the March/April/May 2003 issue of The Financial Journalist, published by the Association for Investment Management and Research (www.aimr.org), headquartered in Charlottesville, Va. AIMR is a non-profit professional association of 60,000 financial analysts, portfolio managers and other investment professionals.

Discussion

Wayne Whitehead from FL posted 9 months ago:

Nice concise discussion with language even I can understand. Thanks

Jack Franklin from CA posted 9 months ago:

Excellent article!

James Etherton from CO posted 9 months ago:

Free Cash Flow is the term used to describe how much is left over after all expenses have been paid. It represents management's effectiveness in providing for mergers, dividends, research and future growth of the company.

Calculating Free Cash Flow is a tedious and time consuming process. As a small investor I am not willing to do it when Yahoo, Value Line and others more professional than I freely provide the information.

If I had only one data point to use in evaluating a company, it would be Free Cash Flow.

Thomas Kraynak from OH posted 9 months ago:

I believe that analyzing the cash flow statement is the best way to evaluate the financial condition of a company.

Calculation of free cash flow.
I usually like companies that have decent free cash flow.
I calculate free cash flow from the most recent quarter and the most recent year.
I make my own calculation (Net Income + Depreciation - Capital Expenditures - Common Dividends paid). I don't know why but my calculation of free cash flow sometimes differs from Yahoo's).

I usually do not buy a company that uses debt or stock sales to pay a dividend. In fact I use this calculation to sell a stock.
I don't like it when (Net Income + Depreciation - Dividends Paid)is negative.
I like to use this for REITs and MLPs.

Debt/Equity ratio
I also like to review the Debt/Equity ratio of a company. I use different ratios for different industries. In general I like companies that have lower Debt/Equity ratios for their industry.

AAII is a nonprofit organization that arms individual investors with the education and tools they need to build wealth.
From stock investing to financial planning and retirement funding, AAII covers all your needs.